May Market Monitor—Fueled by hopes for recovery, the US S&P 500 Benchmark Index finished May with its best two-month return since April 2009. The Index returned 4.76% for the month after returning 12.82% in April, shrinking its YTD loss to negative -4.96% and powering its rally from the March 23rd low to a positive 36% return. Long-trailing value stocks were standouts. In the International Developed markets, European stocks gained 4.6%, and Pan-Asian stocks returned 3.95%. Emerging markets small caps gained 2.4%, outperforming large caps. The US 10-year Treasury closed at 0.66%, up from last month's 0.62%. The US 30-year Treasury closed at 1.41%, up from last month's 1.27%. High yield bonds as measured by Bloomberg US High Yield Credit Index rallied 4.4%. Barclays Muni Bond Index gained 3.2%. Oil rebounded after April's negative price trades to close at $35.32/barrel, up from last month's $19.83 close. US gasoline pump prices increased, closing the month at $2.05/gallon, up from last month's $1.87. Gold was up, closing at $1,743/oz. compared to last month's $1,692.80. Volatility as measured by VIX closed at 27.31, trading as high as 40.32 and as low as 25.92 over the month, but ultimately down from 34.15 at the end of April.
Stock Gains and Social Pain
Despite more than 108,000 US deaths from Covid-19 and deep job losses caused by the economic shutdown to prevent even more fatalities, US stock prices are hovering within 8% of their all-time peaks reached earlier this year. How does this square with the bleak news of the past month?
In a parallel nightmare, we have recently witnessed the largest nationwide protests since the Vietnam War, ignited by the graphic scene of George Floyd being killed by a police officer. Additional shocking scenes confound our sense of right and wrong—a birdwatcher in Central Park, a 75-year old protestor bleeding on the ground, a man shot in his back, and more.
Does the stock market rally seem wildly out of place? When Covid-19 first appeared as a severe threat, financial markets and the real economy briefly marched in sync. The stock market went into freefall, shedding one-third of its value between late February and March. That seemed about right, given the abrupt halt to worldwide economic activity.
Then the market staged a spectacular rally, thanks to some heavy lifting by the Federal Reserve. The Central Bank showered money on the economy, raising the bank’s balance sheet from four trillion to more than seven trillion dollars. In efforts to fill the economic sinkhole left by the shutdown, Congress quickly approved coronavirus relief packages, including the CARES Act, collectively valued at nearly $3 trillion. An additional stimulus package valued at more than $1 trillion is reportedly on the way.
The effect of these extraordinary monetary policies helped propel the S&P 500 to a 40 percent rebound from its trough in March. Asian and European governments and central banks gave their economies a similar boost with massive amounts of aid. And their markets have now begun to catch up to the pace set by the US benchmarks.
Meanwhile, the story on Main Street was taking a starkly different turn. More than 44 million US workers filed unemployment claims over the past 12 weeks. Although workers have begun returning to restaurants, retailers and other businesses hit hard by the coronavirus pandemic, a staggering 13.4 percent of the American workforce reportedly remains unemployed, more than at any point since the Great Depression.
At the same time, steep reductions in tax revenue mean cities, counties and states face unprecedented budget nightmares requiring deep cuts in public services. Public health challenges associated with containing the spread of the coronavirus continue to consume substantial resources. Despite ongoing attempts to open the economy, it’s hard to envision a return to normal any time soon.
Bears and Bulls
The chasm between Wall Street and Main Street raises questions about the durability of the stock market rally, says Jeremy Grantham, co-founder of the investment management firm GMO. His most recent quarterly report points to a startling dichotomy: While the market’s price-earnings ratio is within its top 10% decile historically, the economy is in its worst 10%, perhaps even its worst 1% on record. The outlook has never been so uncertain, Grantham writes, and one-sided optimism is oddly off-key in an environment where prudence and patience would be more appropriate.
Investors express a range of views about future asset prices. And there is plenty of disappointing data on top of the staggering US job losses for those who want to focus on it. In Germany, Europe's largest economy, April trade figures signaled the biggest collapse in exports on record. Data from Japan showed orders for new machines falling to their lowest rate in a decade. And according to the US Bureau of Labor Statistics, the most recent jobs report may not fully reflect the reality of the economic decline.
In a recent webcast, Edward P. Lazear, a renowned labor economist, offered an update on the current state of the US and global economies and discussed factors that may influence a rebound from the COVID-19 crisis. From 2006 to 2009, Lazear was the chairman of the President's Council of Economic Advisers. He is now at Stanford's Graduate School of Business and a senior fellow at the Hoover Institution. The Congressional Budget Office (CBO) forecast for the current quarter (Q2 2020) calls for an annualized rate of decline in GDP on the order of 25 to 50 percent. CBO projects that the economy will begin to grow again in Q3 and Q4 but will remain in a slump, with unemployment averaging 10% in 2021. How long it will take for a full recovery remains to be seen, but Lazear and others make the case that the recession could be over by the end of 2020, and that the economy could return to pre-covid-19 levels within two years, putting the US back on track to where it would have been, had we not had the shutdown, by the end of the decade. A ten-year recovery sounds like a lost decade, but Lazear explains why that’s not the case. Yes, we will have a few years that don't look good relative to where we might have been. But from then on, with the right set of policies, we're actually going to have higher growth than we would have had otherwise. In other words, there’s a good-news story embedded in the coming so-called “lost decade.”
Of course, many factors, including those we can’t foresee, could derail even the most well-conceived measures by the Fed to backstop the system. Shockwaves could be precipitated by severe setbacks for commercial real estate investors, escalating tensions between the US and China, a catastrophic second wave of infections, unsettled elections and further social unrest.
When we try to see around the corner to a post-Covid-19 world, investors and the broader financial system face many serious, unanswered questions about factors affecting corporate profit margins and stock and bond market returns over the next decade. Is the current stimulus enough to repair the damage wrought by the pandemic? Will the long-term consequences of a prolonged shutdown result in more permanent unemployment, higher taxes, greater regulation, a collapse in trade, and a more inflationary environment?
Covid-19 also raises questions about the role and reach of government. Some argue that the economy will improve faster if government gets out of the way and lets business do its job. John Cochrane, a senior fellow at the Hoover Institute and adjunct scholar at the Cato Institute, writes that “Smart people and businesses will figure out which costly steps matter and which ones don’t” as the economy opens up (WSJ, 27-May). “Governments will be tempted to make everything worse” through counterproductive regulations, he says, arguing that we must allow American inventiveness to do its work. The “Careful Economy,” he writes, could dampen any recovery.
Regardless of whether your mindset is bullish or bearish, it pays to retain a sense of healthy skepticism towards any prediction. Every scenario is packed with assumptions that may not hold true. The trajectory of the pandemic and the economy remain uncertain. Much depends on how quickly health officials can contain the crisis, how much the public will cooperate, and whether policies will spark a swift recovery.
Even so, it’s reassuring that many respected economists find it hard to imagine a scenario rivaling the Great Depression in severity and duration—an oft-repeated comparison over the past few months. The breakdown of the financial system was a major reason for the Great Depression and the 2007-2009 recession. Today, however, former Federal Reserve Chairman Ben Bernanke explains that the banks are stronger and better capitalized. He reminds us that a series of policy mistakes around the world exacerbated the length and severity of the Great Depression. Central banks tightened monetary policy to maintain the gold standard. The result was severe deflation, which increased the value of debt and lowered incomes. Governments initially cut spending in reaction to declining revenue. And as economies deteriorated, countries raised trade barriers in an effort to protect their domestic industries. The unintended result was a global contraction in demand, which only deepened the depression.
David Booth, cofounder and Executive Chairman of Dimensional Fund Advisors (DFA), sees reasons for a more positive outlook as well. Unlike the Great Depression, this time governments are jumping in, trying to keep economies afloat and things from getting even worse. The legislative and executive branches have been working together to pass bipartisan relief bills. “What we're seeing today is so different from the Fed's response to the Great Depression. They did all the wrong things then, like draining liquidity out of the system. They didn't know what was happening. Today, the Federal Reserve is doing a great job,” he says.
Booth adds that while unemployment in the US hit 14.7 percent in April, and it's likely to rise further, that blow is being softened by safety net programs such as unemployment insurance. It is true that many people are suffering, and the economy won't recover in only a quarter or two. But scientists around the world are working at record speed on possible treatments and cures, utilizing a sophisticated arsenal of analytical tools. If—when—we're able to get reasonable control of the virus, Booth believes the economy will substantially recover and the downturn will be much shorter than the Great Depression. (Note: just today researchers announced that a common steroid has shown great effectiveness in reversing the most serious effects of the disease.)
What does this mean for investors? I’d like to close with David Booth’s common-sense advice about investing during difficult times:
One: You need a strategy to reach your goals. That's true in life, work or relationships. Deciding on a plan should involve looking at the range and likelihood of possible outcomes. Even though we like to shrink away from uncertainty, dealing with it thoughtfully gives us hope for a better tomorrow. Things might turn around or things might get worse. It's important to be prepared for both possibilities. Stick to a plan that gets you through the tough times so you can benefit from the good ones.
Two: Control what you can control. You can't control stock and bond markets and their returns are inherently unpredictable. What you can control is how much you save and how much investment risk you take.
Three: Judge yourself by the quality of your decisions. Even when we focus on controlling what we can control, things outside our control have an impact. What matters is how we respond and the choices we make going forward. The future is uncertain, but the quality of your decisions doesn't have to be. When you feel good about the choices you make, even when things don't work out the way you had hoped, you have the satisfaction of knowing you did everything you could.
If you have questions or concerns about your long-term strategy, contact me. I am here to help.
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